Robert Schwinn, CPA
Year-End Tax Planning Strategies
Updated: Dec 5, 2022
Planning for taxes before year-end is essential for many reasons. Once the year is over, the ability to reduce your taxes can be greatly diminished. It is also essential to know in advance what your taxes will look like, far ahead of the personal tax filing deadline of April 15th.
Since many small businesses are "pass-through" entities, meaning the tax from business profits is paid with the owner's personal tax return, this article will briefly overview some of the business and personal tax strategies that you should consider before year-end.
General Rule: Accelerate Deductions & Defer Income
Before getting too far into the specifics, the basic and most general rule of tax planning is that often you will want to accelerate deductions and defer income. Therefore, you would want to accelerate deductions into the current year, so you receive the tax deduction this year rather than wait another year.
If possible, you would also want to defer income into a subsequent year. The main reason for deferring income and accelerating deductions is so you can pay less tax in the current year instead of future years, since it is better to have a dollar now than in the future.
There are scenarios where you would instead push deductions into the future or receive income in the current year. Suppose your tax bracket in future years is expected to be significantly higher than in the current year. In that case, you might want to defer deductions into later years when you're in a higher tax bracket and receive income in the current year when you are in a lower tax bracket.
Significant Equipment Purchases
One way to accelerate deductions into the current year is to make significant equipment purchases before year-end. You wouldn't want to buy equipment or make any other significant purchases before year-end just for the sake of saving on taxes. Still, if you were planning to make the purchase soon, it might make sense to do so in the current year and claim the deduction.
If a piece of equipment is purchased, consideration should be given to how much of a deduction should be taken in the current year. The IRS generally requires that the cost of "Fixed Assets" such as equipment, furniture, and leasehold improvements be expensed over multiple years. The reason is that these assets last longer than a year, so the IRS has specific rules as to how many years the cost of these items must be spread over and deducted (i.e., five years for machinery & equipment, seven years for furniture & fixtures).
Some elections can be made for qualifying purchases to expense the entire amount in the current year. Additional considerations should be taken into account, such as planning for higher tax brackets or fluctuations in income in subsequent years. There are also state considerations to keep in mind since not all states follow the rules of the IRS.
Max Out Retirement Plan Contributions
One way to defer income is to contribute to a retirement account that allows a deduction, or to make contributions to a retirement account with "pre-tax" dollars. For example, a traditional IRA contribution could be deductible and reduce your current year's personal income tax. A w-2 employee may be able to participate in a 401k plan and contribute "pre-tax" money into the 401k, meaning the money contributed to a regular 401k is excluded from taxable income.
There are various business retirement accounts available, some of the more common ones being SEP-IRAs, 401ks, or SIMPLE IRAs. Certain retirement plans allow contributions to be made after the year is over but still allow a deduction in the current year. For example, a traditional IRA contribution for 2021 can generally be made until April 15, 2022 and still be deductible in 2021.
Generally, a qualified retirement plan's earnings grow tax-free, and tax is not paid until distributions are taken from the account.
Planning for Capital Gains
Suppose you have significant capital gains from selling stocks this year. In that case, you may want to review your portfolio before the end of the year and sell stocks that are in a loss position. Of course, you wouldn't want taxes to dictate whether to hold or sell your investments, but if it makes sense from an investment standpoint, then the losses would help offset your capital gains. There are IRS wash sale rules to be mindful of, which make it so losses cannot be deducted if you buy substantially identical stock within 30 days before or after the sale of the stock at a loss.
Depending on whether you claim the "standard" or "itemized" deduction on your personal tax return, there are planning strategies to maximize your deductions based on the timing of your charitable contributions. It may make sense to make large donations in a single year rather than spread out the donations over two or more years.
Section 529 Plan Contributions
Certain states offer a tax deduction for contributions made to a Section 529 plan. You should check your state's requirements, as some require that you invest in that State's Section 529 plan to qualify for a deduction. For example, for a New York resident to claim a tax deduction for a Section 529 plan contribution, they must contribute to a New York Section 529 plan.
Connect with your Accountant before the Year is Over
Listed above are just a few tax savings strategies to consider before year-end. A more in-depth analysis should be performed with your accountant to ensure you are properly planning for year-end for your business and your personal taxes.